Why the Cyprus bailout could spark next financial crisis

Washington | It’s a bad time to have your money deposited in a bank in the Mediterranean island nation of Cyprus. And it may just mean some bad days ahead for the rest of us.

Over the weekend, Cyprus reached an agreement with international lenders for bailout help. Part of the agreement: Bank depositors with more than €100,000 in their accounts will take a 9.9 per cent haircut. Even those with less in savings will see their accounts reduced by 6.75 per cent.

That’s right: Anyone with money in a Cypriot bank will have significantly less money when the banks open for business on Tuesday than they did on Friday. Cypriots reacted rationallly by lining up at ATM machines to try to get as much cash out before the money in their accounts is reduced.

What makes this important for people who couldn’t locate Cyprus on a map is this: it is one of the 17 nations using the euro. European officials have spent the past six years moving heaven and earth to ensure that no depositors with the continent’s banks suffer a loss despite the financial strains the banks have been under.

Most dramatically, the Irish government in 2008 backstopped its banks, putting its public finances through a wringer. Even as the Greek economy has fallen into depression and Spanish bank losses on real estate have reached dangerous levels, the European Central Bank and the continent’s government have ensured that bank deposits were safe. They have feared that if depositors in any country were forced to take losses, it would spark a destructive cascade of withdrawals across Europe.

So is Cyprus different?

In a lot of ways, it is separate from the rest of the euro zone, and not just geographically.

Its population is a mere 1.1 million (the Greek population is 10 times as large). It has an unwieldy banking system with liabilities equal to eight times its economic output, compared with 3.5 times for the euro zone as a whole. Many of those deposits are held by wealthy Russians who use Cyprus as a convenient place to park their money.

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Those are the reasons the IMF has insisted on losses for depositors — those, and the fact that rescuing Cyprus’s finances without the €5.8 billion contribution represented by depositors’ losses would have meant a bailout about equivalent to the country’s annual economic output, too much for the fund to stomach.

“The challenges we were facing in Cyprus were of an exceptional nature," said Jeroen Dijsselbloem, the Dutch Finance Minister who helped engineer the plan, according to the Financial Times.

“Therefore, unique measures were determined to be necessary."

The ECB will now be on high alert, monitoring activity in Greece, Spain and beyond for evidence that the Cyprus precedent will result in new runs on those nations’ banks. Expect a flood of central bank liquidity into those nations if there is any hint that depositors across Europe seem to be thinking that Cyprus is the new normal and that their seemingly safe bank deposits could be reduced by 10 per cent without warning.

The best the rest of the world can hope for is that Cyprus’s case is sufficiently unusual that it won’t spark panic in Athens and Madrid (or in Lisbon, Dublin and Rome).

For the past six months, the global financial markets have become increasingly complacent, convinced that the euro zone crisis is, for practical purposes, over.

Cyprus is the test of whether that is correct, or whether the complacency was instead misplaced.

In other words, if there is going to be a new wave of crisis in Europe, historians will be able to trace its starting point back to today’s Cyprus bank bailout.